All Eyes On iQOS' Performance In Philip Morris' First Quarter Earnings

Philip Morris is set to release its first quarter earnings on April 19, wherein revenue growth of over 15% is expected, as compared to the corresponding quarter of the previous year, while earnings are slated to decline a little over 8% to $0.90 per share. Revenue growth is expected to be driven by increased sales of its reduced risk products (RRPs), iQOS in particular, as well as price increases. Meanwhile, lower cigarette volumes, and higher investments behind iQOS’ expansion, will pressure the margins, resulting in a fall in the earnings.

While the year may not have started on the best note, with the rejection of Philip Morris’ proposed claim that its iQOS device presents less of a health risk than traditional cigarettes, by an advisory panel instituted by the FDA, it doesn’t mean that the end won’t be good. The development of reduced risk products, such as iQOS, has been a boon for the company, as it can help reverse the declining volumes it has been faced with recently. And it is this product that the company intends to market as one that can ultimately replace cigarettes. The increased sales of iQOS can be expected to be the main driver for revenue growth in the future, and with the company noting a positive annual profit contribution from its RRP (Reduced Risk Product) portfolio for the first time in late 2017, looking ahead the margin pressure should also ease.

iQOS To Drive Revenue Growth

It is no secret that Philip Morris is betting big on its heated tobacco device – iQOS. The company has spent $4.5 billion to develop, substantiate the reduced-risk profile of, and build manufacturing capacity for this device. After just two years of the commercialization of these devices, 40% of PM’s worldwide commercial expenditure and nearly 75% of its global R&D expenditure have been dedicated to these products. It has been rewarded with higher volumes and increased sales of its heated tobacco sticks which go into the iQOS device. RRP net revenues grew from $64 million to $3.6 billion in 2017, and accounted for almost 13% of the total net revenues, with the products achieving breakeven towards the end of 2017, earlier than expected.

Trefis

In Japan, the market share of the Marlboro HeatSticks grew by 9 points to 13.9% in the fourth quarter of 2017, and reached 14.1% for the month of December, while the offtake share increased by 1.4 points to 19.9% in Q4. This was despite the capacity limitations of HeatSticks at first, and iQOS devices later. The supply is reported to no longer be an issue, placing the company in a good position to take on 2018. Korea, another key market for iQOS, also reported exceptional performance, with the fourth quarter market share of HeatSticks more than doubling sequentially to 5.5%, reflecting growth in existing launch areas, coupled with the impact of national distribution expansion.

The 2017 results from the region were significantly impacted by two markets – Russia and Saudi Arabia. Total industry volume fell 7.2% in Russia due to excise-driven price hikes, together with the prevalence of illicit trade. Despite down-trading by consumers, PM’s market share remained stable. Net pricing, on the other hand, remained challenged due to a competitive environment. Consequently, the company could not nullify the financial impact of the volume decline. While excise tax increases in the region usually occur in January, it is scheduled for July this year, with the weighted-average total excise tax pass-on for the industry being approximately RUB5 per pack, compared to RUB13 last year. Accordingly, PM expects to return to profitable growth this year.

An excise tax-driven price increase in June 2017, resulting in a doubling of cigarette retail prices in Saudi Arabia, drove a cigarette industry volume decline of approximately 28% in the second half of 2017 and 17% for the year. The price hikes caused significant down-trading among consumers, resulting in market share declines for premium Marlboro and mid-price L&M. These factors weighed on the profitability of the company from the region, with the impact set to continue in the first half of FY 2018. Moreover, the other five GCC (Gulf Cooperation Council) countries are also in various stages of implementing a similar excise tax increase, with the United Arab Emirates having already done so in the fourth quarter of 2017. As a result, considerable volume and profit pressure can be anticipated across the area this year. Saudi Arabia and the United Arab Emirates accounted for approximately 60% and 20%, respectively, of the GCC’s cigarette industry volume prior to the 2017 tax increases.

We have a $124 price estimate for Philip Morris, which is higher than the current market price. The charts above have been made using our new, interactive platform. You can click here to modify different drivers, and see their impact on the EPS and price estimate for Philip Morris.

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